"Asking yourself which customers, products, and services don't fit your business model can quickly reveal whether your company is managing profitability effectively, and whether your key managers' actions are aligned," writes Jonathan Byrnes in Islands of Profit in a Sea of Red Ink. "The question really has two parts: what fits? and fits what? A company has to get both right to manage profitability effectively, and they are closely related."
In this excerpt from Islands of Profit in a Sea of Red Ink, Byrnes explains how to answer those two questions through a process comprising three elements: profit mapping, profit levers, and profit management:
Profit mapping shows which accounts, products, and transactions fit the business model (and are profitable). Profit levers are elements of a company's business model that can be adjusted to improve profitability, selecting and penetrating more "good" customers, and turning "bad" customers into "good" customers. And a profit management process is the organizational procedure a company can use to align its day-to-day business activities with its business model.
Let's look at how one national trucking company got it right. Three years ago, this company did not have a good process to manage profitability. Today, it has more than doubled its profit margins. As one key manager put it, "Now our sales reps know exactly what to sell."
PROFIT MAPPING. In the first step, a small group of key sales and operations managers, called the Yield Management Team, thought hard about what was driving their costs.
The Yield Management Team was a small group of managers responsible for pricing trucking services. In a very creative move, the head of the team decided to go beyond his traditional, narrow mandate and look more broadly at all the elements leading to the company's profitability. Through this process, he created a revolutionary new approach to the business that produced major profitability increases. It also led to his promotion to head of the business unit. (You might think about how your company could benefit from this approach.)
They had an insight-the sales department had been selling individual point-to-point movements, but the real cost driver was the whole route, including backhauls. (In a traditional trucking company, a sales rep might sell a truckload movement from, say, Chicago to St. Louis-called the primary or point-to-point movement-and leave the company with the problem of trying to sell the return trip from St. Louis to Chicago, which is called the backhaul.) So a sales rep might charge a price for the primary movement that appeared to make a profit, but the company would lose money if the backhaul price was too low.
They developed a set of cost models for their routes. They also saw that each cost model divided into three components: fixed costs (daily cost of a truck), variable costs (mileage), and special costs (handling, etc.).
Next, they put together a database of all their transactions over a six-month period. They applied the cost models to the transactions to see which customers, services, and routes were profitable and which were not.
They found a few islands of customers that were very profitable-20 to 30 percent margins. They were shocked to find that fully 40 percent of the business was unprofitable-islands of profit in a sea of red ink.
PROFIT LEVERS. While the Yield Management Team was analyzing profitability, the company pushed hard for a general cost reduction-but this was not nearly enough. To increase profitability, they had to engage several profit levers.
First, the team moved aggressively to secure the highly profitable customers by ensuring that they received flawless service, including first priority on capacity.
The next lever was pricing-and it wasn't simply a matter of a price increase. In the past, when the company had sold a point-to-point movement to a customer, the sales reps had to scramble to sell backhaul movements at low rates. If the customer canceled the pickup, the company had to scramble to find a new headhaul. This was very reactive and inefficient.
Under the new regime, the team did two things. First, they decided to charge rates with fixed and variable components. The customer who ordered a truck had to pay a fixed daily charge whether it used the truck or not, while the customer's mileage charge reflected actual use. Second, they incorporated forecast accuracy in pricing. The customer had to forecast its needs a month in advance, and pay an additional charge if the usage was greater than 110 percent of forecast (causing uncovered backhauls) or less than 94 percent of forecast (causing uncovered headhauls).
This changed the customer/company relationship to one of shared risks and rewards, and created a strong incentive for joint planning. Now the trucking company could presell the whole route, receiving a much better price, and could get much better equipment utilization. In return, the company awarded the customer priority on capacity-crucial at peak times of the year-and passed on some of the savings as a price decrease.
In a series of meetings, the team sold the concept to the key customers.
Most of the best customers saw the need for a stable supplier, and understood the wisdom of focusing on joint cost reduction. To further reduce costs, the company scheduled monthly safety meetings with these customers, and agreed to reduce prices even more if safety targets were met.
Also, the trucking company sought to increase its integration with these key customers (providing coordinated services that took the place of tasks the customer formerly did itself), offering services such as loading and inventory processing-further reducing customer costs while building competitive differentiation and switching costs.
Most important, according to a key team manager, the company "stopped saying yes to everyone." With the new bottom-line focus, the team took hard stances. They walked away from customers who were not willing to participate in joint cost reductions and risk/reward sharing. As it turned out, many of these customers came back and accepted the new pricing terms because the company offered the opportunity for them to reduce costs and lock in capacity.
PROFITABILITY MANAGEMENT PROCESS. The profitability management process featured three key components.
First. The Yield Management Team continued periodic reviews of account and service profitability, ensuring that profitability management was permanently built into the company.
Second. The company strengthened day-to-day profitability management at the account level. Previously, account management was primarily a sales task. Now a high-level sales team sets the relationship and pricing, and operations personnel manage the day-to-day account relationship. Sales became so productive that the company was able to reduce its sales force by 50 percent over time.
Third. The company used training to drive bottom-line awareness down to the grassroots level. The goal was to ensure that the front-line sales and operations people understood the profit levers, and that they managed the details of the account relationship to achieve its full profit potential.
The training sessions were held in five-member groups. They were very interactive, with lots of "What would you do if ?" examples and quizzes. In the first wave, the company trained the dispatchers and customer service reps; in the second wave, they trained the support groups, such as billing.
One manager on the Yield Management Team described the change. "At first, the customers thought I was the bad guy. Now it's very rewarding. The hard feelings went away. Before, customer meetings were about price increases; now they're about cost reductions. We start every meeting with a business review of cost takeouts, and only adjust prices if necessary."
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Adapted from Islands of Profit in a Sea of Red Ink by Jonathan Byrnes by arrangement with Portfolio Penguin, a member of Penguin Group (USA), Inc., Copyright 2010 by Jonathan L.S. Byrnes.